The Severe Russian Winter Continues… When’s the Thaw?

The builders are currently finishing construction (those who can afford it) of their properties, while the long-term prospects are still hazy. Money for new projects is lacking. On the other hand, not many people want to initiate new projects in the times of instability. Property owners of major land plots have frozen operations, laying off 100% of staff – financing and investors simply are not there. Many top managers are considering a time-out in Guam, where they can wait out the turmoil and collect their thoughts.

Meanwhile, a serious correction is happening on the Russian market. All the analysts are in agreement: the market now belongs to tenants. Developers who never before worked in these conditions now have to adjust and adapt. “The first to get their bearings were those who experienced the crisis ten years ago,” says Maxim Zhulikov, Chief Specialist in Commercial Real Estate at Penny Lane Realty. “They have immediately lowered lease rates by 30-35% and offered tenants pre-finished spaces, completely ready for work.”

Many property owners took their lead. However, some are still not persuaded by the crisis, leaving rates unadjusted and offering facilities as shell and core. “I leased before, I’m leasing now, and I will lease in the future. If they don’t like it – off to the side; other tenants will come,” said a major developer, answering a question about a switch in accents on the real estate market. He has his arguments; for a number of years, rental spaces were grabbed up during “the digging phase,” and thinking about tenants in these conditions seemed out of place. Now the situation has changed. It is quite possible that the current market conditions will give way to a new generation of developers. Brokers have much to say about pricing policies. “Some property owners are setting prices close to pre-crisis levels. Then they want us to find tenants. But the problem is that the tenants know they can find a better office closer to the center for less money. What can you argue?” asks a broker from one of the big-five consulting companies, spreading his arms in disbelief.

Meanwhile, the consulting companies have got the picture, and now they are more than pleased to defend tenants’ interests over those of the proprietors. “The most flexible are the class B office proprietors,” states Olga Pavlik, Director of Research and Analysis at Praedium Oncor International. “Major developers and property owners of class A business centers are making no sharp adjustments in rates. True, they are ready to do custom renovations for tenants, but only with a corresponding hike in the rate.” Average adjustments on the market are 30-40%. The average cost per sq m in class A offices with finishing is $1,200, while for class B - $700-800. In addition, many tenants are insisting on a fundamental review of lease agreements. They are suggesting that proprietors switch from a fixed rate to a percentage of turnover. And many proprietors, afraid of losing their clients, agree to those conditions. Different scenarios are also under discussion: breaks from rental payments, favorable rates on participation in promo campaigns, reducing the length of the agreement, zero indexation, and a switch to ruble payments.

The subletting market has flourished in the light of economic difficulties. Companies are subletting spaces that were vacated following layoffs, hoping to make at least a little money. According to Cushman & Wakefield Stiles & Riabokobylko, the subletting market currently comprises 80,000 sq m, or 2% of the overall offer (classes A and B). These are negligible figures when you consider that in New York, for example, the subletting market share is 25%. “However, these statistics do not reflect the actual situation,” explains Lada Belaichuk, Deputy Director of Research at Cushman & Wakefield Stiles & Riabokobylko. “The thing is that the extra space surrendered by the tenants is put on the market directly by the property owners.”

More and more companies are choosing to relocate to class B offices. Top managers are frequently holding meetings in cafes and restaurants rather than their own offices, as if they were ashamed of the downgrade in class. Demand for smaller offices has spiked upward on every real estate market. Even the logistics operators that formerly rented out large chunks of warehouse premises are settling for less in conditions of lower consumer demand. Unexpectedly, the hallwayoffice system of office layout has surged in demand. The number of people wishing to rent out – for a time – an office of 100-150 sq m is increasing day by day. “It makes sense economically to build a BC with a narrow layout, and then take it down in a few years and rebuild it,” says Ekaterina Dmitrieva, Director of Development at Forma Group Architecture Factory.

The developers are facing one more problem: they need to pay up on loans, and the banks are in no mood for charity. “We would be glad to lower rental payments, but we have our own obligations. Let the tenants go to the bankers and ask them to lower their rates instead of raising them all the time. Then we can talk about discounts,” Vyacheslav Kaminsky, President of DVI Group, says to retailers with regards to discounts. However, the share of open spaces is going up, and property owners have no choice but seek compromise with tenants. According to Dmitry Zolin, Managing Partner at London Consulting & Management Company | LCMC, some companies in retail pay no rent at all outside of operating and public services costs. These are anchor tenants whose departure would signal doom for the entire shopping center. Retailers’ revenues continue their downward trend. The New Year’s and Christmas peak has given way to a lull. Even the seasonal discounts are not helping. Threatened by the crisis, people have sharply cut their expenses, including vital necessities. Some of shopping centers in Moscow stand half-empty right after opening. However, the crisis is not the only problem, but faulty concepts too – investors were sure that the consumer boom would go on forever. Office real estate is faring no better than retail. “Proprietors are pretty much ready to sign leases under any conditions at all. They will do everything to bring in tenants – the economic situation remains quite difficult,” assents Igor Gorski, Vice President of the Russian Realtors’ Guild. According to data from Praedium Oncor International, the share of vacant spaces comprises 15% on average. “The sides need to reach agreement and find solutions together – they are in the same boat – says Dirk Vikhner, Director for Europe, Russia and the CIS, and Head of the Retail Real Estate Division at Jones Lang LaSalle. “Property owners will not be able to continuously reduce rent, since they themselves have obligations to banks.”

Consulting companies are facing similar problems. Maybe this is not advertised, but it is a known fact: staff reductions reach as much as 3050%. According to Konstantin Kovalev, Managing Partner at Blackwood, the majority of consulting companies were late in their reaction to the crisis: “Right now, many consulting firms are taking steps to save their business, but these steps are far more painful now than they would have been at the start of the crisis.”

Moscow City

A very difficult situation is now in the Moscow City Business Center, the biggest construction project in Moscow which Yuri Luzhkov, Moscow’s Mayor personally controls. Whether an actual construction is happening there remains a question. The only projects that have been officially halted belong to Shalva Chigirinsky (the Russia Tower) and the Moscow Government (the building complex of the Moscow Government). As for other projects, either people keep silence, or developers say that everything is fine. However, the builders working at the Moscow City say that the construction process is nearly dead. The situation remains unclear with the Federation Tower of Mirax Group as well as the Imperia Tower belonging to Pavel Fuchs’s Mos City Group. However, several developers are continuing construction. In particular, completion is under way at the Capital Group’s Capital City and the tower belonging to the Eurasia Investment-Industrial Group. AFI Development, which belongs to Israeli businessman Lev Leviev, is continuing work on the Mall of Russia shopping center: the finishing work is under way.

Frankly saying, this particular business center – the future pride of Moscow City bosses – has suffered worst of all from the ongoing crisis. Market analysts point out that vacancy rates in Russia are the highest in Moscow City, reaching in some cases up to 30%. “However, we understand that the crisis is no problem,” some real estate market players estimate. As a matter of fact, the project faces a number of challenges, ranging from insufficient electric power to problems with transport. The high rises are placed side by side, parking is insufficient, there are not enough overpasses, and none of this would even help, market experts are sure. It would be faster to travel to work by helicopter than by car. And how do you explain to employees that only one car in twenty has the right to park (that is, if he or she makes it, of course). However, both developers and brokers working at the City are sure that the project is just fine. “The vacant spaces at Moscow City say more about the shape of the market than they do about the actual project,” argues Vladimir Pinaev, Managing Director for Corporate Clients and Proprietor Services at Jones Lang LaSalle. “Moscow City has quality spaces, and the whole project will be of a high demand when the market comes to life – given the right price, of course.” Average rental rates for class A office space at Moscow City without finishing remain the highest in Moscow – more than $1,000 per sq m. According to Lada Belaichuk, no deals are currently happening with the Moscow City properties. “This is partially due to a lack of new spaces that will be ready to go on the market soon,” says Lada Belaichuk. However, there is another problem as well. Renting spaces in large buildings at Moscow City is risky today, even if the price is reasonable; the developer may not be able to rent the whole building.

This problem is common for today’s market. It is quite dangerous to rent space in a building that is not yet filled with tenants. For example, Nokia halted finishing work on its store at the new Voentorg after they looked around and saw a totally empty property: only 30% of space had been rented out.

For now, the business center project is battling problems of financing and a lull on the real estate market. Many buildings that were supposed to be commissioned in 2010 are still in the “digging” phase. If the developers manage to rent out six of the 15 major properties, that much will be good news, market analysts say. Mayor Yuri Luzhkov has his own opinion about progress at the business center: speaking at a recent meeting of Moscow’s Government, he recommended that the developers find money and build, build, build.

No deals

Despite the wishes of Moscow’s Mayor, the developers are having more and more trouble finding money and settling up with banks on previous loans. Payment arrears are increasing. If the current trends continue, it is perfectly feasible that the major banks will become the biggest property owners, for example – of the said Moscow City. According to Alexey Panfilov, President of FPC Garant Invest, developers and bankers must find agreement: “Settle the question about possible extensions in loan payments or offering some kind of break from rates. In addition, there are banks, investment companies, and financial companies that are ready to purchase problem loans.” However, not all developers will be able to agree with the banks, Alexey Panfilov assumes, so bankruptcies among 1030% of development companies seem inevitable: “This process started in October 2008 and, apparently, it will continue throughout 2009.”

Selling properties is one of the few options developers have to receive money for loan payments or financing construction. The market is full of such opportunities, the experts argue. Even the developers that just a few months ago would not have dreamed of selling anything are today ready to speak about sale terms. However, very few deals are actually in the spotlight, even though prices on ready-made spaces have lowered by 30-50% relative to pre-crisis levels, according to Konstantin Aprelev, Vice President of the Russian Realtors’ Guild. “The buyers – Western and Russian companies – are out there, but they are in no hurry to give up their money,” Lada Baichuk says. “The prices that owners are disclosing do not satisfy them. The buyers expect the prices to drop even further.”

The companies that manage to proceed with their real estate projects without borrowed funds are doing quite well. These companies prefer step-bystep expansion to rapid expansion, and they were proven right: slow and steady wins the race. Now, in crisis conditions, they are expanding and buying up their leveraged competitors at half-price. For example, Igor Kovpak, proprietor of Kirovsky, a retail chain in Yekaterinburg, last fall purchased at an enormous discount the assets of his competitors, including real estate properties. Lada Belaichuk is sure that the market will not fall into total hibernation: “Some companies are continuing with their projects even now, and many of them are still in the ‘digging’ phase. These are developers who do not face a significant debt burden, and for whom development is merely a diversification of their core business line. They will be able to receive financing from the head office.” According to Lada Belaichuk, the time of shock therapy has passed and the market is slowly coming to life: “Last month, nearly 70 thousand sq m was rented out, even though January is typically a month of low activity. This is actually quite good, as we see the same level as last year.” Surprisingly, but many real estate experts in their long-term market forecasts are waiting for the absolute bottom – the moment when the industry will not drop any further. This is when the future of development projects will clear up, the experts say. First, the experts were expecting the “bottom” in March-April 2009, but now the consensus is September-October 2009. It is also curious that the first company to acknowledge its problems was the Mirax Corporation; the rest stayed silent for as long as they could. True, Sergey Polonsky, Chairman of the Board of Directors at Mirax Group, said that his problems are temporary, even promising to eat his tie if real estate prices drop by 20%. Once real estate prices had dropped in price by 30-40%, he posted a new vacancy on his blog – Mirax is seeking a person capable of changing the world.